CPD: Alternative assets - de-banking and the evolution of private credit

Figure 1 illustrates the net level of debt outstanding between the various entities in the Australian economy at the end of September 2023. Central to the creation of debt are financial corporations, such as banks, as they redirect excess capital from savers and investors to those seeking credit. In September 2023, the demand for credit in Australia, without considering the financial sector, was $90.2bn.^[1]

While credit is an essential element of the modern economy, there have been times when excess credit creation has led to an overheating economy. This subsequently leads to a slowing economy, placing borrowers under pressure and increasing defaults. The most recent example of this dynamic was the Global Financial Crisis (GFC).

As discussed in detail later in this article, over time global authorities have attempted to create policies that will prevent future excessive credit cycles. An unforeseen consequence of these actions has been the phenomena of ‘de-banking’, defined as the closure or denial of banking services to existing or potential customers.

The rise in de-banking globally has provided a significant impetus to the growth of private credit markets. As private credit markets have grown to meet the needs of credit starved borrowers, in turn a growing array of opportunities have presented themselves to fixed income investors.

In its simplest form, the banking system (Figure 2) exists to facilitate the transfer of excess capital (savings) to those needing credit (borrowings). Banks use a combination of their existing equity, deposit capital (savings from account holders) and debt capital (raised through issuing their own debt) to fulfil customer loans.

By matching the savings and borrowings, banks generate a positive net interest margin (NIM), which is the difference between their funding costs and what they charge loan holders. Vital considerations for any bank are:

• How do they attract deposits?
• How much debt, and at what price, should they raise?
• What rate do they need to charge on the loans they make? Taking into consideration the probability and likely severity of defaults.

These factors are key to determining a bank’s NIM and ultimately its profitability and return on equity.

In Australia, banks are regulated by the Australian Prudential Regulation Authority (APRA). APRA’s mandate is to ensure banks operate effectively. A crucial component of this role is to ensure banks have adequate capital (the difference between loans (assets) and liabilities (debt)) to weather any systemic shocks to the banking system.

APRA takes its lead from global regulation provided by the international Basel committee. As a response to the GFC, the Basel Committee updated its rules (Basel III). These rules materially altered requirements for the banks, which in turn led to banks altering their customer mix.

One of the most telling Basel III changes was the common equity Tier 1 requirements for the banking sector. To be compliant, banks must hold an increased amount of capital against their risk-weighted assets (loans). Certain loan types, for instance those to non-prime home loan borrowers or loans to startup firms, were more heavily penalised in terms of the level of capital a bank had to hold against them, often to the point it became uneconomic for banks to lend in these markets.

In Australia, one of the impacts of the regulation change was that banks were encouraged to issue mortgages to pay as you go (PAYG) customers, as the capital requirement on these loans became comparatively very low. For mortgage borrowers that didn’t meet these criteria (i.e. self-employed), sourcing a mortgage through the banks became more challenging and expensive. This in turn created demand for residential mortgage lending outside of the bank markets, and is a classic example of the de-banking process.

In addition to the modifications in capital requirements post the GFC, an increased focus globally on anti-money laundering (AML) has placed additional demands on those providing traditional banking services. These demands have placed increased pressure on legacy banking systems and processes.  The domestic incumbent banks have struggled to adapt their systems to meet the new requirements, with both Westpac and Commonwealth Bank found to have failed their AML obligations; Westpac was fined $1.3b for their failures. To minimise the potential for any further repeats of these fines, domestic banks have begun to limit their exposure to only easily identifiable or ‘vanilla’ customers. This decision has led to further de-banking or the denial of services; a problem that has been recognised by the Federal government, as access to banking is considered a basic right and vital requirement.

Limitations in the legacy banking systems of the incumbent domestic banks have also been a tail wind to non-bank lenders in other ways. Rapid developments in IT, including both software and hardware, have allowed newer non-bank lenders (fintechs) to provide high quality and faster underwriting services to non-core banking customers. The traditional banks have not been able to fully leverage these technological advancements as the cost of integrating them into their legacy systems are prohibitive. However, these emerging fintechs need to access debt markets, both public and private, to access funds as they do not hold deposits.

The domestic demand for credit, whether it be governments, corporations, or consumers, is not diminishing and therefore the parts of the market that have been de-banked have needed to find alternative sources of debt capital. As a result an opportunity has presented itself for alternative providers of capital.

The growth in private credit markets over the last 15 years is largely a response to some of the trends that have driven de-banking. Private credit is a broad label and covers a diverse set of subcategories including:

• direct lending
• distressed debt
• venture debt
• private securitisation (warehousing)
• mezzanine finance.

While lending between non-bank parties dates to the creation of credit, the origin of the current iteration of private credit can be traced back to the 1980s, when insurance companies started to lend to strongly performing companies.

An essential element of private credit is that the debt is not traded on a public market, and generally remains an agreement between the initial parties. This contrasts with public securities, where an investor may purchase a corporate bond at issuance, but has the option to easily sell the security to another investor via a market maker. This functionality means that public markets are generally liquid, allowing investors to trade easily with small bid-ask spreads (the gap between what a party is willing to pay for an asset and what the opposing party is willing to accept.)

Private markets not only exist in credit markets but also equity markets, in the form of private equity.  Private investment markets are undergoing rapid growth, as access to these markets has become more readily available to non-institutional investors. The main attraction for investors is that private markets are less volatile as securities are not being constantly exchanged. However, this lack of liquidity presents a significant risk to an investor because they cannot readily redeem their investment if they require the funds. On the upside, investors are compensated for this lack of liquidity and do not constantly face market risk; that is the risk of material price changes that can quickly reverse.

Blackrock suggests that the global private debt market alone will grow from $1.75 trillion in 2023 to $3.5 trillion by 2028. Ernest and Young estimates suggest that at the end of 2021 the Australian private credit market was $133bn. Contributing to this growth has been the knock-on effects of de-banking. On the demand side, borrowers are also attracted to private credit markets as they can execute complex deals with certainty. Generally, terms, including pricing, are negotiated and set up front with lenders who have a greater risk appetite than the traditional banks. This enhanced risk appetite is partially explained by private credit providers not being leveraged themselves, unlike a bank that needs to hold regulatory capital against their investments.

So, how should investors look to benefit from what is on offer in private credit markets? The first question is to assess whether you are prepared to lock your money away for the term of a deal. If one is accessing these opportunities through a fund manager, while it will be the manager’s responsibility to handle liquidity within limits, an investor should still anticipate reduced liquidity.

While under normal operating conditions private credit investors do not face mark-to-market risk, credit risk remains. Credit risk refers to the risk that a borrower will default on their obligations. The most straightforward way to assess this risk is through a security’s credit rating. However, in private credit, many of the transactions will not be publicly rated. Therefore, an investor is either dependent on their knowledge of the transaction or that of their selected investment manager.

Private credit growth is experiencing material tailwinds globally. In Australia, new investment opportunities are presenting themselves as traditional banks retreat from lending to certain cohorts and non-bank lenders step in and fill the capital shortfall. In return for providing this capital, investors receive an enhanced yield and reduced volatility at the inconvenience of limited liquidity. If investors are looking to capitalise on the opportunities presented by the private credit markets, both the benefits and shortfalls need to be considered.